The last time the “fear index” was this low, a stock market crash was coming

February 17, 2017 | Kim Iskyan

In October 2008, in the throes of the global economic crisis, legendary investor Warren Buffett famously wrote: “Be greedy when everyone is fearful, and fearful when everyone is greedy.” Over the course of his career, he has made a fortune from this contrarian philosophy of going against the herd.

If he’s right, it might be time to be fearful. Why? Because the stock market “fear index” is at its lowest level since 2007. Those who saw this, foresaw the stock market crash, in fact the global economic crisis, which was coming. (Here are 5 things to do before any crisis hits.)

How to measure fear

The “fear index” is another name for the VIX index, which is a measure of anticipated market volatility.

It’s based on option prices of individual stocks in the U.S. S&P 500 index. When investors expect more price fluctuation (that is, for prices to bounce around more), the VIX goes up. And volatility is greatest when markets fall.

As the old saying goes: The market takes the stairs up, and the elevator down.

Quoted as a percentage, the VIX is currently around 11. That generally means the market expects an 11 percent range of movement in the S&P 500 index over the next 30 days. For comparison, the VIX hit an all-time high of 89.53 on October 24, 2008, in the depths of the global economic crisis.

The VIX rises when investors are surprised and scared. Investors panic-buy options to protect against further losses. As a result, implied volatility increases.

(One estimate suggests that if the VIX had existed in 1987 – it was instituted in 1993 – it would have hit 120 during the October 1987 stock market crash in the U.S.)

So the VIX index is a measure of how anxious large investors in the S&P 500 are to insure their portfolios. Put options – which increase in value when the underlying security goes down – are widely used by institutions as insurance against losses in the stocks they own. When investors fear a market decline, put options are increasingly in demand, so the price of put “protection” rises.

Generally speaking, the VIX goes up during times of uncertainty and fear, and goes down when investors are complacent or greedy.

The lowest VIX reading ever recorded was 9.39 on December 15, 2006. In recent days, the index has dipped under 11. According to investment bank Goldman Sachs, since its inception, the VIX index has traded below 11 on only 1.8 percent of trading days (grey lines on chart below).

In recent years, there have been some short-lived declines in the S&P 500 and spikes in the VIX. In August 2015, for example, the S&P 500 dropped 11 percent in a little more than a week, causing the VIX to briefly peak above 50. And in the beginning days of 2016 the VIX surged to more than 30.

But the stock market hasn’t seen elevated volatility since 2011. And, based on current VIX readings, investors don’t expect much volatility.

Right now, investors fear little

One thing is for certain – global stocks have been on a roll. The S&P 500 is up 9.8 percent since the election, and global indices aren’t far behind. The so-called “Trump Rally,” which we expect to end, is based on expectations of higher corporate profits from the new U.S. president’s pro-growth policies. Trump has proposed slashing corporate income taxes from 35 percent to 15 percent, and eliminating many regulations in financial, energy and other industries. (We previously wrote about the industries that will do well under a Trump administration… here.)

Is there a stock market crash coming anytime soon?

Does a low VIX reading point toward an imminent market top? Not necessarily. The rock-bottom VIX only indicates that optimism and complacency are high among the largest investors in the S&P 500 index. This attitude could continue for a while, but it’s a warning (re-read the Buffett quotation at the beginning of this piece).

While rising prices may have already priced-in Trump policy benefits, the implementation of these policies is by no means a certainty. Also, the U.S. Federal Reserve has indicated that it expects to continue to raise interest rates – which will counter President Trump’s expected economic stimulus plans. The more that risk assets (like stocks) rally, the more aggressive the Fed is likely to be in raising rates. After nearly seven years of near-zero rates, tighter monetary policy will be a big challenge to global markets.

This is a difficult mix. The timing is difficult, but the low VIX suggests that the U.S. and global markets might be primed for a correction.

That doesn’t mean it’s time to panic… it just means that you should be careful and selective. Just because the market is complacent, it doesn’t mean you should be.

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